Tax Saving Scheme

Tax Saving options
By Narayan Lodha, Chartered AccountantMarch 31st is nearing; I have to make some investments somewhere. Do you know anybody, who can help me to invest in some investments?
This is what we hear in offices and houses in the time between October and March. We all work 24*7 to make money but we don’t even think of spending few minutes a day to manage our hard-earned money, which ends up with killing our own dreams and plans made for life. We shouldn’t invest our hard earned money just for the heck of doing it.

Tax saving helps us to reduce our tax liability up to certain limit only and proper tax planning help us to save considerable amount of money every year. We have different investment options which help us to save tax, but very few will help us to create wealth and have got less charge.
Below are the lists of few investment products which help us to save our tax:1. Employee Provident Fund2. Public Provident Fund3. National Savings Certificate4. Long term Government Securities5. Bank Deposits6. Life insurance Products7. Pension Products8. Mutual Funds9. ULIPs
1. Employee Provident Fund (EPF):EPF take care need of fund for Retirement, Medical emergencies, House purchase, family obligations, education of children and buying an insurance policy. Your contribution in EPF scheme, which is 12% of basic salary generally, builds a fund available when you retire. The fund is available for some other specific purposes also like, purchasing land or house repaying loan for the same, children education and marriage etc. Employer contribution is also 12%, a part of which goes towards pension fund. An employee can contribute more than 12% also towards building up the fund.
2. Public Provident Fund:Public provident fund or PPF offers good returns with safety and flexibility that is why it is one of the most popular tax saving product.
PPF account can be opened with specified branches of post office or nationalized bank on self or family members’ name. Account has 15 years term that can be extended in the blocks of 5 years after completion of the term. It offers 8% per annum yearly compounded interest. Contribution can be minimum Rs.500 to maximum of Rs.70000 in a year; that can be deposited monthly or yearly.
Apart from qualifying for section 80C, interest earned is free, maturity withdrawals are tax-free and it cannot be attached under the decree of any court of law.
From PPF, Loan can avail from the third year to sixth year up to 25% of the amount available in the preceding second year. Partial withdrawals can be made once every year at any time after sixth year. The amount of withdrawal is limited to 50%of the balance at credit at the end of 4th year immediately preceding the year in which the amount is withdrawn or at the end of the preceding year whichever is lower.
3. National Savings Certificate:National savings certificate (NSC) remains the on shelf tax savings product. Investment in NSC can be made at specified post offices, in denomination of Rs.100, Rs.500, Rs.1000, Rs.5000 and Rs.10000 without any upper cap on investment. The certificate matures in six years and pays 8% half yearly compounded interest. Maturity proceeds of NSC are completely tax free. Premature encashment of NSCs are not allowed, however these can be kept as security to avail loan from banks. Interest earned on NSC is also an investment under section 80C.
4. Long Term Government Securities:Government securities (G-secs) or gilts are sovereign securities, which are issued by the Reserve Bank of India (RBI) on behalf of the Government of India (GOI). The GOI uses these funds to meet its expenditure commitments.Treasury bills are short-term money market instruments, which are issued by the RBI on behalf of the GOI. The GOI uses these funds to meet its short-term financial requirements of the government. The salient features on T-Bills are:These are zero coupon bonds, which are issued at discount to face value and are redeemed at par.No tax is deducted at source and there is minimal default risk.The maximum tenure of these securities is one year.
5. Bank Deposits:Bank deposits are the most popular among fixed income investors. Safety, liquidity and convenience are being the prime reasons for gaining the investors confidence in banks; apart from safety of deposits. Bank fixed deposits are new entrants in 80C league. These form part of overall limit of Rs.100000 for deposits tenure of 5 years or more. However, interest on such investment is not tax exempted.
6. Life insurance Products:Investing in life insurance has got a new look with the launch of ULIP’s (Unit Linked Life Insurance Plans) in the Industry. Yesteryear\'s we had the conception that insurance is all about life cover, risk cover, death benefit. But, now the rapid growth evidencing the entry of private players in to the market has created the wave of ULIP’s, which now has become one of the major investment avenues for Indian Investors.
Following are the broad categories of insurance plans available in the market:1. Whole life policies2. Endowment Policies3. Term policies4. Money Back Policies5. Specialized Policies6. Single Premium Policies7. Unit Linked PoliciesThe tax benefit on investments in life insurance up to Rs.100000 can be availed in a financial years.
7. Pension Products:A pension is a long term savings plan. Monies saved build up a retirement fund. This fund provides a source of regular money to live on in your retirement. It is one of the most tax efficient ways to save money.When people are investing for the long term, it\'s important you have the freedom to choose how and where to invest your money - and the option to change your choice of investments you need or want to.Most people need a pension because:People are living longer: retirement could make up a third of your life.They\'ll need money for their increased leisure time during retirement.
8. Mutual Funds:A mutual fund is a trust, which combines the investments of various investors having similar financial goals. The trust issues the units to the investors in the proportion of their investments. A fund manager then invests these funds in different types of assets, according to the objectives of the scheme. The investment provides return in the form of dividends, interests and capital appreciation. This is distributed to the various investors in the proportion of their contribution to the pool funds.
Investment in mutual funds is advantageous for good number of reasons; Professional management of funds, diversification of investments, tax benefits, liquidity are few to mentioned here.
When a new scheme is launched, funds are available to subscription at par value, known as NFO. Subsequent to NFO, units are available for selling and repurchase based on Net Asset Value or NAV. NAV is market value of all assets net of liabilities. NAV per unit is a common performance indicator of the fund.
But in Mutual Funds only Equity linked savings schemes (ELSS) gives tax benefit.
Each of the above mentioned investment options have got their own advantages and disadvantages. But selecting the right one based on your needs and requirements are very important. I do not recommend one option as the best and the other as bad, But I suggest you to deeply analyse your needs before investing, so that the wealth creation process will be fruitful and profitable.
For more you can reach me at lodhanarayan@hotmail.com

Transfer Pricing Law In India

Transfer Pricing Law In India
Increasing participation of multi-national groups in economic activities in the country has given rise to new and complex issues emerging from transactions entered into between two or more enterprises belonging to the same multi-national group. With a view to provide a detailed statutory framework which can lead to computation of reasonable, fair and equitable profits and tax in India, in the case of such multinational enterprises, the Finance Act, 2001 substituted section 92 with a new section and introduced new sections 92A to 92F in the Income-tax Act, relating to computation of income from an international transaction having regard to the arm's length price, meaning of associated enterprise, meaning of information and documents by persons entering into international transactions and definitions of certain expressions occurring in the said section.Section 92: As substituted by the Finance Act, 2002 provides that any income arising from an international transaction or where the international transaction comprise of only an outgoing, the allowance for such expenses or interest arising from the international transaction shall be determined having regard to the arm's length price. The provisions, however, would not be applicable in a case where the application of arm's length price results in decrease in the overall tax incidence in India in respect of the parties involved in the international transaction.Arm's length price: In accordance with internationally accepted principles, it has been provided that any income arising from an international transaction or an outgoing like expenses or interest from the international transaction between associated enterprises shall be computed having regard to the arm's length price, which is the price that would be charged in the transaction if it had been entered into by unrelated parties in similar conditions. The arm's length price shall be determined by one of the methods specified in Section 92C in the manner prescribed in Rules 10A to 10C that have been notified vide S.O. 808 E dated 21.8.2001.Specified methods are as follows:
a. Comparable uncontrolled price method;b. Resale price method;c. Cost plus method;d. Profit split method ore. Transactional net margin method.
The taxpayer can select the most appropriate method to be applied to any given transaction, but such selection has to be made taking into account the factors prescribed in the Rules. With a view to allow a degree of flexibility in adopting an arm's length price the proviso to sub-section (2) of section 92C provides that where the most appropriate method results in more than one price, a price which differs from the arithmetical mean by an amount not exceeding five percent of such mean may be taken to be the arm's length price, at the option of the assessee.
Associated Enterprises: Section 92A provides meaning of the expression associated enterprises. The enterprises will be taken to be associated enterprises if one enterprise is controlled by the other, or both enterprises are controlled by a common third person. The concept of control adopted in the legislation extends not only to control through holding shares or voting power or the power to appoint the management of an enterprise, but also through debt, blood relationships, and control over various components of the business activity performed by the taxpayer such as control over raw materials, sales and intangibles.
International Transaction: Section 92B provides a broad definition of an international transaction, which is to be read with the definition of transactions given in section 92F. An international transaction is essentially a cross border transaction between associated enterprises in any sort of property, whether tangible or intangible, or in the provision of services, lending of money etc. At least one of the parties to the transaction must be a non-resident. The definition also covers a transaction between two non-residents where for example, one of them has a permanent establishment whose income is taxable in India.
Sub-section (2), of section 92B extends the scope of the definition of international transaction by providing that a transaction entered into with an unrelated person shall be deemed to be a transaction with an associated enterprise, if there exists a prior agreement in relation to the transaction between such other person and the associated enterprise, or the terms of the relevant transaction are determined by the associated enterprise.
An illustration of such a transaction could be where the assessee, being an enterprise resident in India, exports goods to an unrelated person abroad, and there is a separate arrangement or agreement between the unrelated person and an associated enterprise which influences the price at which the goods are exported. In such a case the transaction with the unrelated enterprise will also be subject to transfer pricing regulations.
Documentation: Section 92D provides that every person who has undertaken an international taxation shall keep and maintain such information and documents as specified by rules made by the Board. The Board has also been empowered to specify by rules the period for which the information and documents are required to be retained. The documentation has been prescribed under Rule 10D. Such documentation includes background information on the commercial environment in which the transaction has been entered into, and information regarding the international transaction entered into, the analysis carried out to select the most appropriate method and to identify comparable transactions, and the actual working out of the arm's length price of the transaction. The documentation should be available with the assessee by the specified date defined in section 92F and should be retained for a period of 8 years. During the course of any proceedings under the Act, an AO or Commissioner (Appeals) may require any person who has undertaken an international transaction to furnish any of the information and documents specified under the rule within a period of thirty days from the date of receipt of notice issued in this regard, and such period may be extended by a further period not exceeding thirty days.
Further, Section 92E provides that every person who has entered into an international transaction during a previous year shall obtain a report from an accountant and furnish such report on or before the specified date in the prescribed form and manner. Rule 10E and form No. 3CEB have been notified in this regard. The accountants report only requires furnishing of factual information relating to the international transaction entered into, the arm' s length price determined by the assessee and the method applied in such determination. It also requires an opinion as to whether the prescribed documentation has been maintained.
Burden of Proof: The primary onus is on the taxpayer to determine an arm's length price in accordance with the rules, and to substantiate the same with the prescribed documentation: where such onus is discharged by the assessee and the data used for determining the arm's length price is reliable and correct there can be no intervention by the Assessing Officer (AO). This is made clear in sub-section (3) of section 92C which provides that the AO may intervene only if he is, on the basis of material or information or document in his possession of the opinion that the price charged in the international transaction has not been determined in accordance with the methods prescribed, or information and documents relating to the international transaction have not been kept and maintained by the assessee in accordance with the provisions of section 92D and the rules made there under, or the information or data used in computation of the arm's length price is not reliable or correct ; or the assessee has failed to furnish, within the specified time; any information or document which he was required to furnish by a notice issued under sub-section (3) of section 92D. If any one of such circumstances exists, the AO may reject the price adopted by the assessee and determine the arm's length price in accordance with the same rules. However, an opportunity has to be given to the assessee before determining such price. Thereafter, the AO may compute the total income on the basis of the arm's length price so determined by him under sub-section (4) of section 92C.
Section 92CA provides that where an assessee has entered into an international transaction in any previous year, the AO may, with the prior approval of the Commissioner, refer the computation of arm's length price in relation to the said international transaction to a Transfer Pricing Officer. The Transfer Pricing Officer, after giving the assessee an opportunity of being heard and after making enquiries, shall determine the arm's length price in relation to the international transaction in accordance with sub-section (3) of section 92C. The AO shall then compute the total income of the assessee under sub-section (4) of section 92C having regard to the arm's length price determined by the Transfer Pricing Officer.
The Transfer Pricing Officer means a Joint Commissioner/Deputy Commissioner/Assistant Commissioner authorized by the Board to perform functions of an AO specified in section 92C & 92D.
The first proviso to section 92 C(4) recognizes the commercial reality that even when a transfer pricing adjustment is made under that sub-section the amount represented by the adjustment would not actually have been received in India or would have actually gone out of the country. Therefore no deductions u/s 10A or 10B or under chapter VI-A shall be allowed in respect of the amount of adjustment.
The second proviso to section 92C(4) provides that where the total income of an enterprise is computed by the AO on the basis of the arm's length price as computed by him, the income of the other associated enterprise shall not be recomputed by reason of such determination of arm's length price in the case of the first mentioned enterprise, where the tax has been deducted or such tax was deductible, even if not actually deducted under the provision of chapter VIIB on the amount paid by the first enterprise to the other associate enterprise.
Penalties: Penalties have been provided as a disincentive for non-compliance with procedural requirements. Explanation 7 to sub-section (1) of section 271 provides that where in the case of an assessee who has entered into an international transaction any amount is added or disallowed in computing the total income under sub-sections (1) and (2) of section 92, then, the amount so added or disallowed shall be deemed to represent income in respect of which particulars have been concealed or inaccurate particulars have been furnished. However, no penalty under this provision can be levied where the assessee proves to the satisfaction of the Assessing Officer (AO) or the Commissioner of Income Tax (Appeals) that the price charged or paid in such transaction has been determined in accordance with section 92 in good faith and with due diligence.Section 271AA provides that if any person who has entered into an international transaction fails to keep and maintain any such information and documents as specified under section 92D, the AO or Commissioner of Income Tax (Appeals) may levy a penalty of a sum equal to 2% of the value of international transaction entered into by such person.Section 271BA provides that if any person fails to furnish a report from an accountant as required by section 92E, the AO may levy a penalty of a sum of one lakh rupees.Section 271G provides that if any person who has entered into an international transaction fails to furnish any information or documents as required under section 92D (3), the AO or CIT(A) may levy a penalty equal to 2% of the value of the international transaction.Above mentioned penalties shall not be imposable if the assessee proves that there was reasonable cause for such failures.
Some Important Definitions: Section 92F defines the expressions " accountant arm's length price", "enterprise", "permanent establishment", "specified date" and "transaction" used in section 92,92A, 92B, 92C,92D and 92E. The definition of enterprise is broad and includes a permanent establishment (PE) even though a PE is not a separate legal entity. Consequently, transaction between a foreign enterprise and its PE, for example between the head office abroad and a branch in India, are also subject to these transfer-pricing regulations. Also the regulations would apply to transactions between foreign enterprise and a PE of another foreign enterprise. The term PE has been defined on the lines of the definition found in tax treaties entered into by India with other countries. PE includes a fixed place of business through which the business of the enterprise is wholly or partly carried on.

Straddle and Strangle stretegy

What is Straddle?An options strategy with which the investor holds a position in both a call and put with the same strike price and expiration date.Why it should be used?An investor who is convinced a particular index will make a major directional move, but not sure whether up or down.An investor who anticipates increased volatility in an index, up and/or down around its current level, and a concurrent increase in overlying options’ implied volatility.An investor who would like to take advantage of the leverage that options can provide, and with a limited dollar risk.Example :Let’s assume the price is currently at $15 and we are currently in April 05. Suppose the price of the $15 call option for June 05 has a price of $2. The price of the $15 put option for June 05 has a price of $1. A straddle is achieved by buying both the call and the put for a total of $300: ($2 + $1) x 100 = 300. The investor in this situation will gain if the stock moves higher (because of the long call option) or if the stock goes lower (because of the long put option). Profits will be realized as long as the price of the stock moves by more than $3 per share in either direction. A strangle is used when the investor believes the stock has a better chance of moving in a certain direction, but would still like to be protected in the case of a negative move. For example, let's say you believe the mining results will be positive, meaning you require less downside protection. Instead of buying the put option with the strike price of $15, maybe you should look at buying the $12.50 strike that has a price of $0.25. In this case, buying this put option will lower the cost of the strategy and will also require less of an upward move for you to break even. Using the put option in this strangle will still protect the extreme downside, while putting you, the investor, in a better position to gain from a positive announcement.Strangle An options strategy where the investor holds a position in both a call and put with different strike prices but with the same maturity and underlying asset. This option strategy is profitable only if there are large movements in the price of the underlying asset. This is a good strategy if you think there will be a large price movement in the near future but are unsure of which way that price movement will be. The strategy involves buying an out-of-the-money call and an out-of-the-money put option. A strangle is generally less expensive than a straddle as the contracts are purchased out of the money.

Option

The trading market for Option is so huge and exciting that it commands a dedicated article on itself.

Options
An option is a contract where the buyer has the “right” (depends on buyer to execute it), but not the “obligation” (legally bonded) to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date. An option is a security, just like a stock or bond, and constitutes a binding legal contract with strictly defined terms and conditions.

Futures Vs Options
Remember from the previous article, Futures are contracts where both the buyer and the seller have the obligation to honor the contract whereas option does not involve any obligation for both the parties. A contract is a zero sum game i.e. one party will book loss while the other take home the profit. If the contract is futures, the losing party will pay the winning party. However, in options, the buyer will decide whether to execute the contract. You will understand this by the following example.

Let say there is a contract between you and me which says that I will buy one kg of gold at Rs. 1,000 per gm from you on March 1st, 2009. I am the buyer of this contract and you are the seller. So we will either go for cash settlement or you have to deliver the gold to me. Now suppose on the date of settlement i.e. March 1st, 2009, price of gold is Rs. 500 per gram. Thus, the market price of gold on March 1st, 2009 is lower than the contract price.

If the contract were Futures, I would have to buy the gold from you because I have the “obligation” to do so. Hence, I will pay you Rs. 1,000 per gm and you will deliver me the gold. Hence, you make profit while I book loss. Good for you, Bad for me!!

However, if the contract were an Option, I would not have executed it i.e. would not have bought the gold from you. I would have let the contract expire (i.e. do nothing and wait till March 1st, 2009 passes by). How can I do so? I can do it because Options gives me (the buyer) the “right” and not the “obligation” to buy it. Thus, an option would protect me from any adverse movement in the price of underlying asset. In an option, seller has no right because he is compensated by the buyer by paying option premium. Thus, the buyer of an option contract has the “right” but the seller of option contract has the “obligation” to honor the option.

So you may now be wondering that why on earth somebody will ever buy a futures contract when options contract are better. We must know that option has a “premium” attached to it which is called “Options Premium”. This is the amount that a buyer of option contract has to pay the seller of the option contract in exchange for higher flexibility and protection against adverse price movement in the value of underlying. Thus, if I have to buy an option contract from you, I will pay a premium to the seller i.e. You.

Options Vs Stocks
In order for you to better understand the benefits of trading options you must first understand some of the similarities and differences between options and stocks.

Similarities:
• Listed Options are securities, just like stocks.
• Options trade like stocks, with buyers making bids and sellers making offers.
• Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.

Differences:
• Options are derivatives, unlike stocks (i.e, options derive their value from something else, the underlying security).
• Options have expiration dates, while stocks do not.
• There is not a fixed number of options, as there are with stocks available e.g. there could tens or even hundreds of options written on the same stock
• Stockowners have a share of the company, with voting and dividend rights. Options convey no such rights.

Remember these options are not issued or written by companies who stocks act as underlying asset. These options are generally written by brokers or traders for investors.

Options Terminology

Options Premium
An option Premium is the price of the option that a buyer pays to purchase the contract from the seller.

Strike Price
The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ) can be bought or sold as specified in the option contract from the seller. The strike price also helps to identify whether an option is In-the-Money, At-the-Money, or Out-of-the-Money when compared to the price of the underlying security.

Expiration Date
The Expiration Date is the day on which the option is no longer valid and ceases to exist.

Classes of Options
There are two classes of options – American Option and European Option. The key differences are:

1. American option can be exercised before the expiration while an European option is exercised only on the expiration date.
2. Dividends can be issued by the underlying stock in an American option while it is not the case in European option

Types of Options
There are only two types of options: Call option and Put option. In this article we will discuss only European options i.e. options which can not be executed before the agreed upon date.

Call Options
A Call Option is an option to “buy” a stock (underlying) at a specific price on a certain date. The buyer of call option holds the rights while the seller has the obligation to honor the contract. The buyer of a call option enters the contract assuming that the value of underlying will increase in future and benefit him. The seller thinks otherwise i.e. the stock price will not go up and hence the buyer will not execute the contract. So he (seller) will keep the option premium to himself – that would be his profit. Hence, the buyer will execute the contract only when the market price of underlying stock is higher than the strike price.

Example 1 – I bought a call option from you with the following feature: Underlying is an Infosys Stock, Exercise price is Rs. 1100 and expiration period is Jan 24, 2009. Option premium is Rs. 100 per underlying stock and the option is written on only 1 stock.

How call option helps me (the buyer) in realizing profits. Let us assume that the stock price on Jan 24, 2009 is Rs. 1250. Thus, I will execute the call option and you will sell the stock to me for Rs. 1100 and NOT at the current price. I will take that stock from you and sell it for Rs. 1250 in the open market and book a profit of Rs. 1250 – Rs. 1100 – Rs. 100 (Option premium) = Rs. 50. Now look at my return on investment and NOT on amount of investment. My return on investment (ROI) is = (Profit * 100 / Total Cost or investment) %
= 50*100/100 = 50%

Compare this to someone who invested in Infosys stock and NOT in the option. If he bought the stock at Rs. 1000 and sold for Rs. 1250 in the market, his profit would be
= (Profit * 100 / Total Cost or investment) %
= (250* 100 /1000) = 25%

Isn’t it great? One golden rule of investment – Don’t measure your profit or loss based on “absolute value of profit or loss” but on return on investment (ROI).

Remember this – The buyer of a call option will execute the contract only when the market price of the underlying stock will be higher than the strike price of the stock. This is because the buyer will buy the stock from the seller at a lower cost and sell in the open market to book the difference as profit. However, if the market price of underlying stock is less than that of the exercise price, the buyer will let the option expire. In the above example, if the stock price of Infosys on Jan 24, 2009 were Rs. 1090, I will not exercise the contract! Thus, my only loss would be Rs. 100, the option premium that I paid to the seller (you).

Put Options
Put options are options to sell a stock at a specific price on a certain date. Put options mean “right to sell”. It is just the opposite of a call option. The buyer of a put option holds the right to sell while the seller has the obligation to buy. Here, the buyer assumes that the price of underlying asset will go down in future and he will benefit from the put option. Hence, the buyer of a put option will execute the contract only when the market price of underlying stock is lower than the strike price.

Profit realization for the buyer - When do you make profit by selling something? Only when you buy something for X amount and sell it for Y amount where Y>X. Or, you sell someone a product at a price higher than the market price. Why will someone buy a product at a price higher than the market price? He will do it only when he has signed a contract to do so. This is put option which protects and benefits its buyer from any downward movement in the stock price.

State of an option
In-the-Money option – This is when strike price is less than the market price for a call option or the strike price is more than the market price for a put option.
At-the-money – This is when strike price is equal to the market price.
Out-of-the-money – This is when the strike price is more than the market price for the call option while the strike price is less than the market price for the put option.

How to read an option traded listed on an exchange
If you read any business newspaper you may find quotations like this:

INFOSYSTCH Jan 29 CA 1,020.00 51.00 51.00 50.00 51.00

What does this mean? It simply means it is an option with
1. Underlying as Infosys stock
2. Jan 29 is the expiry date
3. to BUY (because it is a “call”) Infosys stock - CA is Call Option
4. 1020.00 is the Strike Price
5. The numbers (51.00, 51.00, 50.00, 51.00) shown after the strike are high price, low price, previous close and Last price respectively.

INFOSYSTCH Feb 26 PA 1,020.00 35.00 35.00 52.00 35.00
It simply means it is an option to SELL (because it is a “put”) Infosys stock with similar details.

Table1: Representation of rights and obligations


CALL
PUT

BUYER (Long)
Right but not the obligation to buy
Right but not the obligation to sell

SELLER (Short)
Obligation to sell
Obligation to buy



Common terminology – people who buy options are also called \"holders\" or are considered to be “Long” on option and, those who sell options are also called \"writers\" or are considered as “Short” on option.

Remember this:
Long –> Buy
Short –> Sell (Selling the right to someone else is like buying obligation for oneself)

Call option –> Right to buy
Put option –> Right to sell (Selling the right to someone else is like buying obligation for oneself)

Long call –> Buy the right to buy
Short call –> Sell the right to buy (Selling the right to someone else is like buying obligation for oneself)

Long put –> Buy the right to sell
Short put –> Sell the right to sell (Selling the right to someone else is like buying obligation for oneself)

Hence, if I buy a call option, I will say “I am Long Call” or “I am a Call Holder”. People who buy options have a right to exercise.

When a Call is exercised, Call holders may buy stock at the strike price from the Call seller, who is required to sell stock at the strike price to the Call holder. When a Put is exercised, Put holders (buyers) may sell stock at the strike price to the Put seller, who is required to buy stock at the strike price from the Put holder. Neither Call holders nor Put holders are obligated to buy or sell; they simply have the rights to do so, and may choose to exercise or not to exercise based upon their own judgment.

Let us discuss example 1 from the point of view of put option in the next example.

Example 2 – I bought a put option from you with the following feature: Underlying is an Infosys Stock, Exercise price is Rs. 1100 and expiration period is Jan 24, 2009. Option premium is Rs. 100 per underlying stock and the option is written on only 1 stock. The current price of Infosys stock is say, Rs. 1050.

How put option helps me (the buyer) in realizing profits and protecting my interests. Let us assume that the stock price on Jan 24, 2009 is Rs. 950. Thus, I will execute the put option and you will buy the stock from me at Rs. 1100 and NOT at the current price which is Rs. 900. Thus, my profit is Rs. 1100 – Rs. 950 – Rs. 100 (Option premium) = Rs. 50. Now look at my return on investment and NOT on amount of investment. My return on investment (ROI) is = (Profit * 100 / Total Cost or investment) %
= 50*100/100 = 50%

Compare this to someone who invested in Infosys stock and NOT in the option. The value of Infosys stocks has come down from Rs. 1050 to Rs. 950; hence, his profit would be
= (Profit * 100 / Total Cost or investment) %
= (-100* 100 /1000) = - 10% i.e. a loss of 5%.

Gain, Loss and Breakeven Table


Calls
Puts


Long
Short
Long
Short

Maximum gain
Infinite
Premium
Limited


Maximum loss
Premium
Infinite



Breakeven
Market price = Strike Price + Premium
Market Price = Strike Price - Premium



Potential Benefits of Options
• Greater return for smaller amount invested
• Less risk
• Less initial investment
• Diversify portfolio

These previous examples introduced how options can provide investors with more alternatives, allowing them to specify, precisely, the amount of risk they are willing to take in their holdings. If used on a 1-to-1 basis with the underlying shares, then options can be used to invest in stocks with limited risk, to insure stock investments held, or to set levels of market exposure consistent with one\'s investment strategy. Options can also be used as alternatives to stock investments (one option for each 100 shares), giving investors the ability to profit from favorable market moves just as if they held the underlying security, but with lower potential risk due to a lower initial investment.

Final few words
I know you have to read a lot of things which might sound vague and confusing, which is totally understandable. It took me few weeks to completely understand the concepts of F&O! I am not kidding. However, they are wonderful concepts and knowing them only add to your investments knowledge and profile. Go through both Part-1 and Part-2 regularly for sometime. To help you, I have decided to introduce a section on Q&A to test what you learnt in this article. I will publish the answers in the next article.

Test your skills
1. __________ option conveys the right to Buy.
A. Call
B. Put

2. ________ option conveys the right to Sell.
A. Call
B. Put

3. Long on an option means_____.
A. Buy
B. Sell

4. For a call option when the strike price is more than the market price, it is ____.
A. In-the-money
B. At-the-money
C. Out-of-the-money

5. For a put option when the strike price is less than the market price, it is ____.
A. In-the-money
B. At-the-money
C. Out-of-the-money

6. The buyer of a call option will exercise the option when ____.
A. Strike price is higher than the market price
B. Strike price is lower than the market price
C. Strike price is equal to the market price

Top 4 Questions from our readers – Part 1 of F&O

Q1. One thing I want to ask if I have both long n short positions in future for different share on different scripts and the market moves in reverse direction how can I square off my position with minimum loss. Reader: Binay Mohanty
Answer: You can square off by placing opposite orders on the same scripts i.e. if you are long on XYZ, go short on XYZ and square off your position. Only loss here would be the transaction cost. In case of options, loss will only be the option premium.

Q2. How equities futures are traded please explain with example actually I didn’t understood how equity futures are actually settled? Reader: Nupur Suri
Answer: Futures are traded on exchange – just like stocks. There are ask-bids for them as well. Across the world, equities futures are settled in two ways:
1. Cash settlement – Futures contracts are written on underlying asset. So the buyer and the seller can agree not to take actual delivery of underlying asset. Instead they will do a cash settlement, where the loser will pay difference of price as cash to the winner.
2. Physical delivery – In this case, the seller will make a physical delivery of underlying asset to the buyer and accept cash from the buyer.

However, in India, there is only one way of settling derivatives – Cash Settlement.

Q3. I would also like to ask you about the OTC products and their use. Could you throw some light in the OTC products, in simple language and full depth insight? Reader: Dhritiman Das
Answer: There are thousands of OTC (Over The Counter) products in the market. They are NOT traded on any exchange. Instead a broker writes or facilitates such agreement between the buyer and the seller. These contracts are highly customized to suit the buyer and/or seller specifications. Hence, the contract size, expiry date, settlement type and contract cycles are all customized, which are not possible for exchange traded futures. You can find OTC on forex, bonds, stocks, commodities (gold) etc.

Q4. I wanted to know y does a future contract in equities doesn’t have specified circuit levels while it does in commodity? Reader: Sandeep Lodaya

Answer: I believe you meant circuit breakers. A circuit-breaker is a device that halts trading in a stock if the price changes by a pre-determined percentage on a given day. The stock exchanges currently have 2, 5, 10 and 20 per cent circuit breakers on stocks that are not part of the derivatives segment.
There is not circuit breaker in derivatives because people think it is against free market trade. Believers in free market say that such things will only make investors jittery and create panic. There is circuit breaker in commodity because prices rise or fall in commodities are directly linked to the economy. Hence, government has imposed a circuit breaker on commodity prices

Equity Linked Savings Scheme

Equity Linked Savings Scheme

Definition: Equity Linked Savings Scheme refers to ELSS. ELSS as the name clearly suggests is a savings scheme linked to equity markets. It is a type of mutual fund, which additionally offers tax benefits to the investors.

Key Features and benefits of ELSS are:
ELSS is a fund with a lock-in period of 3 years.
It offers tax benefit to the investors under section 80c of the income tax Act up to a maximum limit of 1 Lac per annum.
Investment has to be for long term, any expectation of short term gains is not appropriate.
Involves a little bit of risk because of equity allocation.

ELSS helps an investor to get addicted to investments and savings by offering systematic investment option.
ELSS is very beneficial to salaried people.
Up to March 31,2005 an investor could claim only rebate under Section 88 if invested in ELSS and the maximum amount that could be invested in ELSS was only Rs.10,000/-. But from March 31, 2006 the investment limit in ELSS has been increased to Rs.1, 00, 000/- and this entire investment is eligible for deduction under sec 80C of Income tax Act, 1961.
Comparison between ELSS and ULIPs:
ULIPs and ELSS works almost in the similar way as both offers tax benefit. Money will be mostly invested in the equity markets in both the cases. I would like to put before few points which differentiates ULIPs and ELSS.
ELSS plans are offered by Asset Management Companies, where as ULIPs are mostly offered by Life Insurance Companies.
ELSS plans does not offer switching facility, but ULIPs offers switching facility to the investors, which helps an investor to safe guard his money in the time of market fluctuations by allowing the switch over of funds from equity to debt instruments.
The fund management charges in ELSS would always be higher than ULIPs.
SIP in ELSS is not convenient to investors, as money invested on monthly basis has to be locked for three years from the date of investment of the respective monthly investment. Where as in case of ULIPs investment amount and its return can be taken back after completion of 3 years from the date of first monthly investment made.
The Investment strategy of ELSS is not that strong when compare to the ULIPs as the investment strategy of ULIPs are governed by law.
Advantages of ELSS over NSC and PPF
Main advantage of ELSS is its short lock-in period. Maturity period of NSC is 6 years and PPF is 15 years.
Since it is an equity linked scheme earning potential is very high.
Investor can opt for dividend option and get some gains during the lock-in period.
Investor can opt for Systematic Investment Plan.
Some ELSS schemes also offer personal accident death cover insurance.
Provides 30 to 40% returns compared to 8% in NSC and PPF.
Market risk is also there in ELSS